Finding Alpha via Covered Index Writing

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  • CFA Institute

    Finding Alpha via Covered Index WritingAuthor(s): Joanne M. Hill, Venkatesh Balasubramanian, Krag (Buzz) Gregory and IngridTierensSource: Financial Analysts Journal, Vol. 62, No. 5 (Sep. - Oct., 2006), pp. 29-46Published by: CFA InstituteStable URL: .Accessed: 12/06/2014 16:08

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  • Financial Analysts Journal Volume 62 . Number 5

    D2006, Goldman, Sachs & Co.

    Finding Alpha via Covered Index Writing

    Joanne M. Hill, Venkatesh Balasubramanian, Krag (Buzz) Gregory, and Ingrid Tierens, CFA

    Covered S&P 500 Index call strategies have, on average, outperformed the S&P 500 Index over the past 15+ years while realizing lower standard deviations of returns. This analysis dissects the strategy underlying the BuyWrite Monthly Index on the S&P 500. The BXM is the most broadly quoted benchmarkfor index call-selling strategies. Also discussed are alternative structured S&P 500 option-overwriting strategies, which have even more attractive risk-return trade-offs than the BXM because they take advantage of the implicit positive risk premium of equities and potentially adjust the strike price of the call sold on the basis of the volatility environment.

    T he new S&P 500 BuyWrite Index (BXM) of the Chicago Board Options Exchange (CBOE) has outperformed the S&P 500 Index with only two-thirds of its risk.

    What's the catch? Well, for one thing, a user of the BXM needs to be willing to accept some underper- formance in spectacularly strong equity markets when everyone else is bragging about their hot stock picks. The relatively boring strategy to cap- ture the BXM returns consists of going long S&P 500 exposure while shorting at-the-money (ATM) call options on the S&P 500. It does best relative to the index when equity markets are quiet, posting mod- erate or falling returns, and is, therefore, worth studying further in the current environment.

    Academics and investment consultants have studied the BXM in terms of its return and risk characteristics both alone and in combination with other asset classes.1 In the period we studied (1 January 1990 to 31 October 2005), the BXM's annu- alized return of 11.0 percent was about 60 bps above that of the S&P 500, with a standard deviation of less than 10 percent (compared with about 14.5 percent for the S&P 500). Although some of the lower risk in terms of standard deviation came from eliminating upside swings in rising markets, as Figure 1 and Figure 2 show, the track record has been impressive in both bull and bear markets.

    Some of the best returns of the BXM relative to the S&P 500 have been in low-volatility periods like

    that of the early 1990s and in the bear market of 2000-2002. In some sustained periods, such as 1995-1998, the BXM underperformed the S&P 500 by more than 5 percentage points each year.

    Recently, with investors attracted by the return and risk characteristics, as well as regular cash flows, of the BXM, several funds and structured products have been created to track the index.2 With the recent introduction of options on the S&P 500 SPDR (S&P Depositary Receipts) exchange- traded funds (SPY), these strategies can also be used for covered call writing on the SPY. The BXM can also serve as a benchmark for more active or alter- natively structured options strategies designed to outperform the index.

    We analyze the strategy underlying the BXM and some alternative structured index option- overwriting strategies that have even more attrac- tive risk-return trade-offs than the BXM, including fixed-strike overwriting strategies and a flexible strategy that dynamically adjusts the strike based on the volatility environment.

    Factors Driving the Performance of a Covered Call Strategy Before jumping into the specifics of the BXM and alternative overwriting strategies, we remind read- ers of the factors that drive the performance of these strategies. We have identified the following drivers of overwriting strategy returns:3 1. The fair call premium: the premium that would

    go to the call seller who had perfect volatility foresight in a world with no trading costs; that is, the call is priced at the volatility realized over the life of the option, rather than at implied volatility, and there is no bid-ask spread.

    Joanne M. Hill is managing director at Goldman, Sachs & Co., New York City. Venkatesh Balasubramanian is an associate at Goldman, Sachs & Co., New York City. Krag (Buzz) Gregory and Ingrid Tierens, CFA, are vice presidents at Goldman, Sachs & Co., New York City.

    September/October 2006 29

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  • Financial Analysts Journal

    Figure 1. Cumulative Total Return on the BXM and S&P 500, 1 January 1990 to 31 October 2005

    31 December 1989 = 100


    S&P 500 500









    50 89 91 93 95 97 99 01 03 05

    Sources: CBOE and Standard & Poor's.

    Figure 2. Annual Total Return on the BXM and S&P 500, 1 January 1990 to 31 October 2005

    Annual Return %





    0 F

    -10 1

    -20 -

    -30 I

    90 92 94 96 98 00 02 04 05

    g3S&P 500 LI BXM

    Sources: CBOE and Standard & Poor's.

    30 ?2006, Goldman, Sachs & Co.

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  • Finding Alpha via Covered Index Writing

    2. The volatility premium: the premium that cap- tures the impact of selling options at implied volatility instead of at the volatility realized over the life of the option.

    3. The exercise cost: the component of the call pre- mium that reflects the market impact of execut- ing the sale. The bid-offer spread is the basis for this cost unless the transaction size is large enough to move the price.

    4. The trading cost: the loss in call premium as a result of the bid-ask spread. As we demonstrate later, Items 1-3 are the

    most important contributors to performance. Dis- cussions of covered index-selling strategies are usually restricted, however, to Items 1 and 2: the ability to collect a steady premium that enhances performance and the opportunity to capture a spread of implied volatility over realized volatility, which has been mostly positive at the index level. Because of the general emphasis on these two issues, we provide more details about them before we discuss the significance of the third important point, exercise cost.

    Call Option Premium Levels. An attractive feature of call-overwriting strategies is that the call sold generates a monthly cash flow much like inter- est or dividends. However, these cash flows have important differences in regard to how they are col- lected. First, the option premium reflects the proba- bility that the seller will incur a loss through exercise

    of the option by the buyer at expiration. Second, tax considerations need to be taken into account. In the United States, for example, the call premium is tax- able as a capital gain, which for most U.S.-based investors is taxed at a higher rate than dividends.4

    Figure 3 shows the level of one-month S&P 500 call premiums historically for ATM options and for options 2 percent and 5 percent out of the money.5 The premiums for these options averaged, respec- tively, 2.1 percent, 1.1 percent, and 0.4 percent over the past 15+ years. The variation over time is pri- marily a result of shifts in volatility reflected in option prices, but premiums also move higher with the level of interest rates relative to S&P 500 divi- dend yields. Note that these premiums have recently been at the lower end of their range because both volatility and short-term interest rates have been at lower levels (and with improved corporate cash levels and more favorable dividend tax treat- ment, dividend yields have been shifting higher).

    The Volatility Connection. Another reason index-overwriting strategies have such attractive return properties is that they capitalize on inves- tors' and traders' fears of a financial disaster. Options contain a premium for the volatility envi- ronment expected to prevail during the life of the option. This premium reflects the risk of having a large move that would cause a loss to the option seller. Ever since the crash in October 1987, the volatility implied in S&P 500 options, especially

    Figure 3. One-Month S&P 500 Call Option Premiums for Various Strikes, 1 January 1990 to 31 October 2005

    Option Premium (% of spot)





    89 91 93 95 97 99 01 03 05

    ATM Call - 2% OTM Call 5% OTM Call

    Source: Goldman Sachs.

    September/October 2006 31

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  • Financial Analysts Journal

    those with strike prices at or below the index, has contained a premium for "crash" or "downside gap" risk-the risk that all stocks will fall together in jumps so that trading out of positions will be difficult.

    Figure 4 shows the implied volatility of ATM one-month S&P 500 index options back to 1990. Only in the highest-volatility regimes has realized volatility moved higher than the volatility implied in option prices. The average spread between one- month implied and realized volatility has been 2.4 percentage points for 1990 through October 2005. As Figure 5 shows, however, many times during the bear market conditions of 2000-2002, the actual market risk experienced was higher than that priced into the S&P 500 options.

    The existence of differences between the implied volatility of S&P 500 options among strike prices is referred to as the "skew." As shown in Figure 4, implied volatility for ATM options is nor- mally higher than realized volatility for the S&P 500. The spread of implied-to-realized volatility, how- ever, is wider for OTM put options than for OTM call options. For example, over the period January 1990 through October 2005, the implied volatility of the 2 percent S&P 500 OTM put options averaged 3.9 percentage points above realized volatility. In

    contrast, the implied volatility of the 2 percent S&P 500 OTM call options averaged 1.5 percentage points above that of realized one-month volatility.

    The existence of the skew has two, related explanations that imply higher expected volatility in declining markets than in rising markets: (1) Mar- kets have a greater tendency to have gap or jump moves when they fall than when they rise. The cause can be a reaction to unexpected negative mac- roeconomic or geopolitical events. (2) Stocks are more correlated in falling markets than they are in rising markets, or stated differently, good news comes one stock at a time whereas bad news tends to affect many companies simultaneously. The implication for option-selling strategies is that investors receive higher compensation, in volatility terms, for committing to buy in a declining market than they do for committing to sell in a rising mar- ket. Nevertheless, the spread between implied and realized volatility for the S&P 500 has remained positive, even for 2 percent OTM call options.

    The Forgotten Factor: Exercise Cost. The fair call premium positively contributes to the per- formance of overwriting strategies, and the index volatility premium usually also adds value, but the return lost from calls that expire in the money (ITM)

    Figure 4. S&P 500 ATM One-Month Option: Implied and Realized Volatility, 1 January 1990 to 31 October 2005

    Volatility (%7)




    Source: Goldman Sachs.

    32 c2006, Goldman, Sachs & Co.

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  • Finding Alpha via Covered Index Writing

    Figure 5. S&P 500 ATM One-Month Option: Implied vs. Realized Volatility Spread, 1 January 1990 to 31 October 2005

    Volatility Spread (%)




    0 ................



    -15 I

    89 91 93 95 97 99 01 03 05

    Note: The average spread was 2.4 percentage points; the median, 2.7 percentage points.

    Source: Goldman Sachs.

    can easily overwhelm both, especially for calls struck at the money. In spite of the sizable magni- tude of this cost (it was, on average, close to 2 percent a month for ATM calls for 1990 through October 2005), discussions of covered call strategies too often ignore this component. The exercise cost is by definition negative, and it is capped at zero.

    The success of a covered call strategy, there- fore, hinges as much on minimizing this exercise cost as on capturing the fair call value and the implied versus realized volatility premium. If an investor expects a positive risk premium associated with equities, the investor implicitly expects ATM calls to expire in the money. If the investor wants to reduce the expected exercise loss, the investor should consider OTM strikes and make a trade-off between the reduction in expected exercise cost and the reduction in the call premium associated with moving from at the money to out of the money. We present empirical evidence that overwriting strate- gies can be significantly enhanced without adding much risk by selecting such OTM strategies.

    BXM Construction Compared with Alternatives The BXM introduced in 2002 reflects a strategy of going long the S&P 500 and selling (writing) a one- month ATM call option on the S&P 500 on the third Friday of each month (the option expiration day).6 The BXM methodology assumes that this European- style call option will be sold at a price equal to the volume-weighted average of the prices of the option from 11:30 a.m. to 12 p.m. EST.7 The option is held until expiration one month later, when the strategy rolls and new near-term ATM call options are sold against the long S&P 500 holding. The option pre- mium and any dividends on the S&P 500 cons...